“Financing Growth Through Development Agreements”		«BACK
	by Dennis L. Monroe
	from August 2004 Franchise Times

Franchising, at its core, is a means of financing growth. Many effective systems do not franchise because they have enough available capital — Darden’s (who owns Red Lobster and Olive Garden) and Starbucks are excellent examples of such systems. Those companies desiring to franchise but who do not have extensive capital, however, often must choose to take on partners who (hopefully) have the financial ability to grow their system. There have been many articles in this column discussing the types of financing tools a franchisor has in assisting franchisees, and the most important one is an effective development agreement.

In its basic form, a development agreement gives the franchisee a right to develop specific future sites in a certain area. It can give the franchisee the right to develop one site or hundreds of sites, depending upon the desired breadth and depth of the system (e.g., expansion into new parts of the country or, perhaps, international markets). As an example, targeted development agreements are more advantageous when the system is mature and the agreement is designed to “in-fill” additional sites in a metropolitan area, whereas broad-based development agreements may be more appropriate for smaller systems seeking to provide incentives for major development. When structured with creative incentives and options, an effective and comprehensive franchise development agreement can be one of the best ways to spur development and provide the franchisee with the certainty of growth. Further, for the franchisee, such a development agreement creates a substantial asset that has real value that can attract investors and/or private equity funds and financing.

1. Ability to Develop. Determine the type of franchisee who will have the resources, know-how, and professional advice and development skills to meet the system’s perceived growth needs. Too often, young franchise organizations mistakenly promote that its system has sold a large number of franchise locations under a development agreement when, in effect, the developer at the time has no track record of development. It is imperative that a franchisor selects franchisees that are experienced in the operations of the franchise system and have a track record of opening sites efficiently and timely.

2. Funding. The franchisor must make sure the franchisees have or will have the ability to fund the contracted-for development (i.e., obtain appropriate liquidity, take reasonable steps to secure equity, and have strong senior lender relationships to provide the necessary leverage for effective development).

3. Reasonable Territories. Determine which territories are most likely to constitute effective development areas. Granting development agreements for “in-filling” of already-developed areas is probably not the wisest approach. Such agreements give rise to all sorts of encroachment issues and impact the real value of the system. (This is not the case when the person granting the development agreement is an existing developer for the territory, but it is problematic if there are multiple franchisees in a given territory.) Broad-based development agreements are effective for significantly undeveloped metropolitan areas or areas that have been “seeded” with franchisor corporate stores, but the franchisor must always be realistic as to the size of the area. Often times, an overly large area can cause the franchisee to concentrate too heavily on development rather than focusing on the operational areas of the business. Therefore, it is best to find an area that can be reasonably developed within a period of 5 to 7 years, after which time reasonable development schedules can be established.

4. Recognize Development Constraints. A development agreement needs to take into account the development constraints and laws in the proposed area that will be granted under the development agreement. Certain geographic areas, such as the northeastern part of the United States, are more difficult to develop (e.g., finding fee properties is very problematic, ground leases are the norm for franchises that are real estate intensive, and rent can be very high for leasehold franchises). This also holds true in the Pacific Southwest. Too often, a franchisor does not take into account development constraints and, thus, imposes upon the franchisee developer unrealistic development obligations.

Incentives are essential to a successful development agreement program. The following are some specific incentives that can be utilized.

1. Provide Flexibility. Provide for a development schedule that is flexible rather than rigid and takes into account varying circumstances. The key is to insure the franchisee is making a good-faith effort to develop the territory. If a development schedule is not met, the franchisor is put in a difficult position of setting a precedent by granting an extension or modification and, thereby, opening themselves to an onslaught of additional requests for extensions from other parties. The franchisor must establish reasonable development goals that can be met by the franchisee; and if unforeseen issues develop, the franchisor should grant extensions of time for development.

2. Right of First Refusal. An effective development agreement may also grant to the developer the right of first refusal as to the sale of existing franchises the franchisor has in the territory. Under this right, the franchisor says to the franchisee “this is your territory, and we want you to take charge.” Further, if the developing franchisee is able to effectively develop a territory, it is wise for the franchisor to provide rights of first refusal or options to develop contiguous areas.

3. Sale of Corporate Stores. Another incentive may be for the franchisor to sell its existing corporate stores in the franchisee’s development territory to the franchisee on an installment basis. This will, hopefully, preserve some of the franchisee’s cash for new store development and provide the franchisee with a base of cash flow and a decrease of working capital requirements.

4. Options for More Development. If the franchisee developer has met its initial development goals, additional time exclusivity may be a great incentive for additional development.

Every franchise development agreement should provide for certain technical aspects. These include:

1. Multiple Entities. The use of multiple entities by the developing franchisee may assist in obtaining equity or debt for development costs. Obviously, a franchisor wants assurance of “developer control,” but the franchisor should be flexible.

2. Speedy Dispute Resolution. An effective development agreement should provide for a speedy alternative dispute resolution process if a franchisor is arbitrary in approving site selection, thus stalling a franchisee’s ability to develop.

3. Basic Terms Certainty. The franchisor should provide a franchisee with certainty as to the basic terms of the franchise agreement for each developed site. While most development agreements provide the franchisee will utilize the then-current franchise agreement, it is important that basic economic terms are consistent during the development process.

In conclusion, the development agreement is an effective tool for spurring development and financing growth in a franchise system. There are a number of specialized techniques and tools that can be used within the development agreement to create a strong business relationship between the franchisor and franchisee. A realistic approach to development and the franchisee’s ability to develop are the key threshold issues. The fact that a franchisor may receive a high up-front fee is not much of a benefit if the development agreement is not effectively executed upon.